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Choosing good stocks is hard, even for investment professionals. There are numerous quantitative and qualitative factors to consider, such as a company’s earnings power, management capability, the fundamentals of the industry it operates in, and the regulatory environment, to mention a few. Although stock prices should, in theory, reflect all of this information, we believe there are pockets of inefficiency in the equity markets that can be exploited. One such opportunity is mimicking the buying patterns of hedge funds (read the details here).

Activist investors can be a good source of investment ideas. Given the usually large stakes that these hedge funds amass in a particular stock before launching an activist campaign, their interests are generally in-line with other shareholders. They can be a thorn on the side of the company management teams that they target but the actions they seek, whether it is returning more capital to shareholders or selling off certain businesses or the entire company, are generally beneficial to the stock price.

Abercrombie & Fitch Co. (NYSE:ANF) is a $3.0 billion market cap company that sells casual sportswear apparel under the Abercrombie & Fitch, abercrombie, Hollister, REUHL and Gilly Hicks brands. It sells its merchandise through stores in the U.S., Canada, Europe and Asia as well as through its website operations.

Similar to its peers, Abercrombie has been pressured by heightened promotional activity in the teen apparel market as well as the growing popularity of “fast fashion” retailers such as Hennes & Mauritz’s H&M, Inditex’s Zara and Forever 21, resulting in negative same store sales growth over the past year. These headwinds are reflected in the lackluster return for the stock, which returned 4% over the past 12 months. To better compete with rivals, Abercrombie is in the middle of repositioning its Hollister chain as a fast fashion brand but the financial impact from the transformation have yet to be felt.

Since early December 2013, Engaged Capital, which owns a 0.5% stake in Abercrombie & Fitch Co. (NYSE:ANF), has been pushing the company to replace long-time CEO Michael Jeffries or sell itself to a private equity buyer. The hedge fund was partially successful, as Abercrombie named Arthur Martinez, the former CEO of Sears Roebuck & Co., as its outside chairman and added two more directors to its board in January. Not satisfied, Engaged Capital continued its activist campaign, nominating five candidates to its 12-member board in February.

Abercrombie & Fitch Co. (NYSE:ANF) trades at a forward P/E multiple of 16.8X, in-line with the 16.9X for its peer group of apparel retailers, although on a EV/EBITDA basis, the shares look cheaper at 5.2X versus 6.7X for peers. The company’s 9% revenue decline (and even worse earnings declines) over the past year is in sharp contrast to the flattish results for the industry, while its operating margin remains below-average. Abercrombie’s financial objective is to expand its margins and improve capital allocation, leading to a higher return on invested capital, which currently stands at roughly 5% versus 8% for peers. For 2014, management expects a high single digit decline in comparable store sales, 20% growth in direct-to-consumer (Internet) sales, flat to slightly lower gross margins and $2.15-2.35 in EPS. Consensus estimates are at the high end of this range, implying the market has confidence in management’s ability to deliver on its financial targets.

With a clean balance sheet and decent cash flow generation, Abercrombie & Fitch Co. (NYSE:ANF) could be a good candidate for a private equity buyout. However, with the CEO remaining in place, it will be difficult to get management’s cooperation for such a move. In such a scenario, the company can still offer investors upside by improving its profitability and better positioning itself to leverage the fast fashion trend. Otherwise, management will feel more pressure from Glenn Welling and possibly other disgruntled investors.

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